How Bitcoin Transaction Fees Are Determined

Every time you send value over the Bitcoin network, you should include a small fee for miners. The amount of the transaction fee you pay is largely your decision. But the more you attach, the faster your transaction is likely to be included in the next block and confirmed on the ledger.

Centralised payment methods such as banks, PayPal and MoneyGram, calculate the amount you pay in fees as a percentage of the value you send.

With Bitcoin, however, the ideal transaction fee is determined by the amount of data that makes up a transaction. Contrary to what many people believe, the value of the transaction is not what determines the size of its data. A transaction of one dollar may contain more data than one that is worth a million dollars.

A transaction grows in size according to the number of inputs your Bitcoin wallet needs to combine to create an output. For example, a smaller transaction fee will be needed to send 1 BTC from a single input than if your wallet combines four inputs of 0.25 BTC.

In other words, if you receive 1 BTC and you send it to another person, you will pay less of a fee than if you receive several smaller payments that your wallet then has to combine into 1 BTC before sending.

According to a 2015 statement by core developer Gavin Andresen on Bitcoin’s stackexchange page, for a transaction to go through the Bitcoin network, it shouldn’t exceed 100,000 bytes.

‘There could be a miner that is mining transactions that are over 100K’, he explains, ‘but I don’t think there is. And if there is such a miner, or you mine the transaction yourself, then the limit would be the 1,000,000 byte block size limit’.

Another user on the platform who goes by the pseudonym Marek proposes that the ideal fee to pay is 0.0001 BTC per every 1000 bytes of data.

You can find online calculators to help you determine how much to pay in transaction fees. The most popular ones include Estimatefee.com, Bitcoinfees.info and Bitcoinfees.earn.com.

As a casual user, however, you need not worry about calculating transaction data or ideal fees. Most wallets, especially those accessed through smartphones and designed for less technical users, automatically calculate and suggest ideal fees, allowing you to choose among ‘low’, ‘medium’ or ‘high’.

Why pay transaction fees?

Bitcoin is a community-supported payment method. It relies on members to voluntarily contribute powerful computers known as miners to secure transactions on its public ledger—otherwise known as the blockchain.

The first layer of incentive is the mining reward, or newly created coins that the protocol releases every ten minutes. Transaction fees are the second layer. They incentivise members to make computers available to the network.

The mining reward halves every four years. In 2018, a miner receives 12.5 BTC every ten minutes. The reward will halve to 6.25 BTC in the year 2020, which will be the third time in the life of Bitcoin that the reward has been halved.

Mining, in greater detail, is the process of maintaining the public ledger. Computers in the network put together proposed transactions that are then combined every ten minutes in batches known as blocks.

Miners then compete to solve a mathematical problem provided by the protocol. The computer that finds the solution first gets its block accepted by the entire community as the next valid section of the blockchain.

At each ten-minute confirmation, all the transactions fees included in a block, along with the block reward, go to the miner whose computer wins the competition to solve the mathematical problem.

Are fees mandatory?

Theoretically, attaching a fee when you send a Bitcoin transaction is voluntary. The purpose of doing so is to encourage miners to give priority to your transaction when putting together the next block.

This means the miners confirm your transaction or add it to the next block faster than transactions with no fees attached. Whatever amount you decide, the network will eventually confirm your transaction even if you attach a zero fee.

Imagine the analogy of customers queueing to receive support service from a company. The company offers a special package in which a customer could choose to pay an extra fee. The fee would guarantee that every time the customer needs support, they receive priority treatment and are served faster than those who haven’t paid extra.

In the end, every customer who seeks customer support receives attention, but those who choose not to pay the extra fee wait longer.

The situation is similar with Bitcoin. Transactions that have zero fees attached ultimately get confirmed. But the sender and receiver could wait hours or even days while miners give priority to transactions that offer a reward for confirmation.

As a transaction ages, however, its chances of being included in a block eventually increase, because the network generally gives older transactions priority even if they have no fees attached.

The final incentive

As a deflationary currency, Bitcoin has a 21 million cap on how many coins will ultimately go into circulation. The halving of the reward is designed to achieve progress towards this cap. Once no more rewards are released to miners (meaning no new coins are being created), transaction fees will become the only incentive for miners to keep their computers running and confirming transactions.

This doesn’t necessarily mean Bitcoin users will incur huge costs in fees in order to use the network. Protocols such as Segregated Witness (SegWit) and the Lightning Network are being deployed to ensure that the fees remain just fractions of a cent.

With increased adoption and a growing number of transactions across the globe, miners will still be able to receive value that is either equivalent to or worth more than the cost they put into running their computers on the network.

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